Contractual Dualism, Market Power and Informality

Two stylized representations are often found in the academic and policy literature oninformality and formality in developing countries. The first is that the informal (or unregulated)sector is more competitive than the formal (or regulated) sector. The second is that contractenforcement is easier in the formal sector than in the informal sector, precisely because theformal sector comes under the purview of state regulation. The basic contention of this paperis that these two representations are not compatible with each other. We develop a searchtheoreticmodel of contractual dualism in the labor market where the inability to commit tocontracts in the informal sector leads to employer market power in equilibrium, while anenforced minimum wage in the formal sector provides employers with a commitmenttechnology but which reduces their market power in equilibrium. The contributions of thispaper are three-fold. It (i) provides the micro-underpinnings for endogenous determination ofemployer market power in the formal and informal sectors due to contractual dualism in thetwo sectors, (ii) offers a unified and coherent setup whereby a host of salient features ofdeveloping country labor markets can be explained together, and (iii) places the originalStiglerian prescription of the optimal (unemployment minimizing) minimum wage in thebroader context of labor markets where formal job creation is costly, and where formalemployment, informal employment, and unemployment co-exist....